Bonds Longterm Liabilities Longterm Liabilities A L OE

Bonds: Long-term Liabilities

Long-term Liabilities A = L + OE Debt Securities Equity Securities • Long-term liabilities are debts and obligations that a company expects to satisfy in more than one year or beyond its normal operating cycle, whichever is longer. • GAAP require that long-term liabilities be recognized and recorded when an obligation occurs even though the obligation may not be due for many years. • Long-term liabilities are generally valued at the amount of money needed to pay the debt or at the fair market. • A liability is classified as long-term when it is due beyond one year or beyond the normal operating cycle. • Because of the complex nature of many long-term liabilities, extensive disclosure in the notes to the financial statements are often required. • Leveraging is the concept of borrowing funds to earn a profit higher than the interest that must be paid on the borrowing.

Types of Long-Term Debt § Bond payable—the most common type of long-term debt; a more complex financial instrument than a note; usually involves debt to many creditors § Note payable—a promissory note that represents a loan from a bank or other creditor § Mortgage—a long-term debt secured by real property; usually paid in equal monthly installments; each payment includes interest on the debt and a reduction in the debt § The simplest journal entry for a bond is:

The Nature of Bonds § A bond is a security, usually long-term, representing money that a corporation borrows from the investing public. • A bond entails a promise to repay the amount borrowed, called the principal, on a specified date and to pay interest at a specified rate at specified times, usually semiannually. • When a public corporation decides to issue bonds, it must receive approval from the SEC to borrow the funds. The SEC reviews the corporation’s financial health and the specific terms of the bond indenture, which is a contract that defines the rights, privileges, and limitations of the bondholders, including such things as the maturity date, interest payment dates, and the interest rate. • As evidence of debt to the bondholders, the corporation provides each of them with a bond certificate.

Bond Issue: Prices and Interest Rates (slide 1 of 2) § A bond issue is the total value of bonds issued at one time (e. g. 1, 000 bonds @ $1, 000 per bond = $1, 000) • Prices of bonds are stated in terms of a percentage of the face value of the bonds. § When a bond sells at exactly 100, it is said to sell at face value (or par value). § A bond issue quoted at 103 ½ means that a $1, 000 bond costs $1, 035 ($1, 000 × 1. 035). It is said to sell at premium. § A $1, 000 bond quoted at 87. 62 would be selling at a discount and would cost the buyer $876. 20

Journal Entry in its simplest form Issued 200 -$1, 000 bonds at 6% interest, face value, April 1, 2003, semi-annual payments on April 1 and October 1.

Bond Issue: Prices and Interest Rates (slide 2 of 2) • The face interest rate is the fixed rate of interest paid to bondholders based on the face value of the bonds. • The market interest rate (or effective interest rate) is the rate of interest paid in the market on bonds of similar risk. • The market interest rate fluctuates daily. This fluctuation may cause bonds to sell at either a discount or a premium. • A discount equals the excess of the face value over the issue price. The issue price will be less than the face value when the market interest rate is higher than the face interest rate. • A premium equals the excess of the issue price over the face value. The issue price will be more than the face value when the market interest rate is lower than the face interest rate.

Characteristics of Bonds (slide 1 of 2) § Unsecured bonds (or debenture bonds) are issued on the basis of a corporation’s general credit. § Secured bonds carry a pledge of certain corporate assets as a guarantee of repayment. § When all bonds of an issue mature at the same time, they are called term bonds. § When the bonds of an issue mature on different dates, they are called serial bonds. § Callable bonds give the issuer the right to buy back and retire the bonds before maturity at a specified call price, which is usually above face value such as 104.

Characteristics of Bonds (slide 2 of 2) § When a company retires a bond issue before its maturity date, it is called early extinguishment of debt. § Convertible bonds allow the bondholder to exchange a bond for a specified number of shares of common stock. § Registered bonds are issued in the names of the bondholders. The issuing organization keeps a record of the bondholders’ names and addresses and pays them interest by check. § Coupon bonds are not registered with the organization. Instead, they bear coupons that the bondholder removes on the interest payment dates and presents at a bank for collection.

Using Present Value to Value a Bond § A bond’s value is determined by summing the following two present value amounts: • a series of fixed interest payments • a single payment at maturity § The amount of interest a bond pays is fixed over its life. § The market interest rate varies from day to day and is the rate used to determine the bond’s present value. • Thus, the amount investors are willing to pay for a bond varies because the bond’s present value changes as the market interest rate changes. (See image next slide) • For more on Time Value of Money, go to: http: //terrytube. net/pellgrant/timevalueofmoney/

Using Present Value to Value a $20, 000, 9 Percent, Five-Year Bond

Amortizing a Bond Discount $400, 000 (slide 1 of 2) $396, 520 § The bond discount affects interest expense each year and should be amortized over the life of the bond issue. • To have each year’s interest expense reflect the market interest rate, the discount must be allocated over the remaining life of the bonds as an increase in the interest expense each period. Thus, interest expense for each period will exceed the actual payment of interest by the amount of the bond discount amortized over the period. This process is called amortization of the bond discount. • In this way, the unamortized bond discount will decrease gradually over time, and the carrying value of the bond issue (face value less unamortized discount) will increase gradually. By the maturity date, the carrying value of the bond issue will equal its face value, and the unamortized bond discount will be zero.

Amortizing a Bond Discount $400, 000, at 97. 63. Note: Sold between interest dates. Sept 1 and March 1 payment dates. • The straight-line method equalizes amortization of a bond discount for each interest period in the life of the bonds. • The effective interest method applies a constant interest rate to the carrying value of the bonds at the beginning of each interest period. This constant rate is the market rate (i. e. , effective rate) at the time the bonds were issued. The amount amortized each period is the difference between the interest computed by using the market rate and the actual interest paid to bondholders.

Amortizing a Bond Premium $400, 000, 10 year, 10%, on interest dates, April 1, Oct. 1 § Like a discount, a bond premium must be amortized over the life of the bonds so that it can be matched to its effects on interest expense during that period. • • The premium is in effect a reduction, in advance, of the total interest paid on the bonds over the life of the bond issue. Under the straightline method, the bond premium is spread evenly over the life of the bond issue.

Year End Accruals

Balance Sheet Presentation

Retirement and Conversion of Bonds § Two ways a company can reduce its bond debt are by: • Retiring the bonds § Retiring a bond issue before its maturity date can be to a company’s advantage. For example, when interest rates drop, many companies refinance their bonds at the lower rate. § Bonds may be retired either by calling the bonds or by buying them back from bondholders on the open market. • Converting the bonds into common stock § When a bondholder converts bonds to common stock, the company records the common stock at the carrying value of the bonds. § The bond liability and the unamortized discount or premium are written off the books. For this reason, no gain or loss on the transaction is recorded.

Sale of Bonds Between Interest Dates § When corporations issue bonds between interest payment dates, they generally collect from the investors the interest that would have accrued for the partial period preceding the issue date. • At the end of the first interest period, they pay the interest for the entire period. In other words, the interest collected when bonds are sold is returned to investors on the next interest payment date. • There are two reasons for this procedure: § It saves on the bookkeeping costs that would be required if the interest due each bondholder had to be computed for a different time period. § When accrued interest is collected in advance, the amount is subtracted from the full interest paid on the interest payment date, and the resulting interest expense represents the amount for the time the money was borrowed.

Year-End Accrual of Bond Interest Expense § Bond interest payment dates rarely correspond with a company’s fiscal year. • Therefore, an adjustment must be made to accrue the interest expense on the bonds from the last interest payment date to the end of the fiscal year. • In addition, any discount or premium on the bonds must be amortized for the partial period.

Bond Handout: a six-page handout that walks you thru the calculations and journal entries for bonds, each a different scenario.

Long-Term Leases § A company can obtain an operating asset by: • Borrowing money and buying the asset • Renting the asset on a short-term lease (called an operating lease) § The risks of ownership of the asset remain with the lessor (the owner), and the lease is shorter than the asset’s useful life. • Obtaining the asset on a long-term lease § Accounting standards require that a long-term lease be treated as a capital lease when it meets all of the following conditions: • It cannot be canceled. • Its duration is about the same as the useful life of the asset. • It stipulates that the lessee has the option to buy the asset at a nominal price at the end of the lease. § Structuring long-term leases in such a way that they do not appear as liabilities on the balance sheet is called off-balancesheet financing.

Pension Liabilities § A pension plan is a contract that requires a company to pay benefits to its employees after they retire. • The contributions from employer and employees are usually paid into a pension fund, which is invested on behalf of the employees. • There are two kinds of pension plans: § Defined contribution plan—The employer makes a fixed annual contribution, usually a percentage of the employee’s gross pay. Retirement payments vary depending on how much the employee’s retirement account earns. § Defined benefit plan—The employer contributes an amount annually to fund estimated future pension liability. • Employers whose pension plans do not have sufficient assets to cover the present value of their pension obligations must record the amount of the shortfall as a liability.

Evaluating the Decision to Issue Long-Term Debt § Issuing common stock has two advantages over issuing long-term debt: • Permanent financing—Common stock does not have to be paid back. • Dividend payment is optional. § Issuing long-term debt, however, has the following advantages: • Common stockholders do not relinquish any of their control over the company because bondholders and creditors do not have voting rights. • The interest on debt is tax-deductible, whereas dividends are not. • If a corporation earns more from the funds it raises by incurring longterm debt than it pays in interest on the debt, the excess will increase its earnings for the stockholders. This concept is called financial leverage. § Financial leverage is advantageous as long as a company is able to make timely interest payments and repay the debt at maturity. § Because failure to do so can force a company into bankruptcy, a company must assess the financial risk involved.

Debt to Equity and Interest Coverage Ratios § To assess how much debt to carry, managers compute the debt to equity ratio, which shows the amount of debt a company carries in relation to its stockholders’ equity. The higher this ratio, the greater the financial risk. § The interest coverage ratio measures the degree of protection a company has from default on interest payments. The lower the ratio, the greater the financial risk.